• Capital goods are allocated incorrectly
• Capital investments are inappropriate
• Labor is misallocated, thus,
• As a result, the economy underperformed
from the point of view of realizing the mutual
gains from exchange, employing resources
efficiently, and satisfying the demands of
• Inflation is a rise in the general level of prices of
goods and services in an economy over a period
• When the general price level rises, each unit of
currency buys fewer goods and services i.e. an
erosion in the purchasing power of money.
• The current rate of inflation 8.8% (as of Jestha
2068) as disclosed by NRB.
• Demand pull inflation:
Increase in price level due
to excess demand over
• Cost push inflation:
Increase in price level due
to rise in cost of
• Effects on production
• Effect on output and
• Effects on economic
• Effects on distribution of
In sum, moderate level of inflation is boon for the economic growth
(contradictory views) but, the excess level of inflation/hyper inflation is
economically unsound, politically dangerous, and moral disastrous.
Measures of Inflation
• Basically, inflation occurs due to the excessive
supply of money, excessive expenditure and
scarcity of goods.
• Thus, the measures of inflation focus on
reducing the supply of money, optimizing the
expenditure, and increasing level of level of
Tools of measuring inflation
• Monetary measures: CRR, SLR, interest rate, open market
• Fiscal measures: Budgetary measures – reduction of govt.
expenditure, imposition of taxes, public borrowings, etc
• Income policy: Wage policy with consideration of trade
unions because wages have cyclical effects on all the
economic activities in the economy.
• Other measures: Increase in level of production, direct
price control, quota, etc
What’s the effect of inflation on GDP?
(Increase, decrease, stable ???)
Discuss the role of current price hike on
petroleum products on inflation & GDP?
(Inflation & GDP – increase, decrease,
Year Inflation GDP Growth rate Year Inflation GDP Growth rate
1980 9.8 -2.32 1995 7.68 3.47
1981 13.45 8.34 1996 7.18 5.34
1982 10.38 3.78 1997 8.1 5.26
1983 14.2 -2.98 1998 8.33 2.94
1984 6.21 9.68 1999 11.38 4.48
1985 4.13 6.15 2000 3.39 6.12
1986 15.85 4.57 2001 2.44 5.63
1987 13.29 1.7 2002 2.9 0.12
1988 11.02 7.7 2003 4.74 3.95
1989 8.08 4.33 2004 3.96 4.68
1990 8.93 4.64 2005 4.54 3.48
1991 7.94 6.37 2006 7.96 3.37
1992 21.06 4.11 2007 6.2 3.41
1993 8.87 3.85 2008 6.69 6.11
1994 8.95 8.22 2009 12.63 4.41
1995 7.68 3.47 2010 9.56 4.55
1996 7.18 5.34
Correlation coefficient between GDP Growth rate and Inflation is -0.14 which shows that
there is significant (p = 0.45) negative relationship between the variables.
Is there any single measure sufficient to
curve the inflationary pressure?
• Of course not!
• No one measure is sufficient to control the
• Both the monetary and fiscal measures are
prime to curve the inflationary problems.
Along with, the income policy and the other
measures are equally important.
What is the solution to these problems?
– Market discipline/regulated market
– Government correctives
• Fiscal policy
• Mix of fiscal and monetary policy
• After Keynes
– Market equilibrium
Terms to be noted:
Liquidity trap & Crowding out
• Keynesian World View: Liquidity trap makes
monetary policy ineffective
• Monetarist World View: Crowding out makes
fiscal policy ineffective
• Business cycle: The recurring and fluctuating
levels of economic activity that an economy
experiences over a long period of time (?).
• The five stages of the business cycle are growth
(expansion), peak, recession (contraction), trough
• At one time, business cycles were thought to be
extremely regular, with predictable
durations, but today they are widely believed to
be irregular, varying in frequency, magnitude and
• Since the World War II, most business cycles have
lasted three to five years from peak to peak.
• The average duration of an expansion is 44.8
months and the average duration of a recession
is 11 months.
• As a comparison, the Great Depression - which
saw a decline in economic activity from 1929 to
1933 - lasted 43 months.
Note: these data are based on US economy
• Expansion: The phase of the business
cycle when the economy moves from a trough
to a peak. It is a period when business activity
surges and gross domestic product expands
until it reaches a peak. Also known as an
• Peak: The highest point between the end of
an economic expansion and the start of a
contraction in a business cycle.
• Recession: A period in which real output falls for
6 months or more.
• A significant decline in activity across the
economy, lasting longer than a few months. It is
visible in industrial production, employment, real
income and wholesale-retail trade.
• The technical indicator of a recession is two
consecutive quarters of negative economic
growth as measured by a country's gross
domestic product (GDP).
• Depression: Recession merges into depression
when there is a general decline in economic
activity. There is a considerable reduction of
output, employment, income, demand and
• A severe and prolonged recession
characterized by inefficient economic
productivity, high unemployment and falling
• Trough: The stage of the economy's business
cycle that marks the end of a period of
declining business activity and the transition
Recovery: A period of renewed growth of real
output following a recession.
A period of increasing business activity signaling
the end of a recession. Much like a recession, an
economic recovery is not always easy to
recognize until at least several months after it
Economists use a variety of indicators, including
GDP, inflation, financial markets and
unemployment to analyze the state of the
economy and determine whether a recovery is in
Some loopholes of Business Cycle
• Do you identify the periods of business cycle? i.e.
growth to growth, recovery to recovery, peak to
• Does the cycle follow the consistent phases? i.e.
Recovery – peak – recession – trough – recovery.
• Would it be possible to jump from one phase to
• Do you identify the starting period of each
phases of business cycle?, etc